Key points:
DeFi allows users to access crypto-financial services with just a wallet and some cryptocurrency. Decentralized applications (dApps) enable lending, liquidity provision, swaps, staking, and more across various blockchains.
While Ethereum was the original home of DeFi, most blockchains with smart contract capabilities now have DeFi dApps, including layer 2 solutions such as Arbitrum and Optimism. Smart contracts are necessary for the services offered by DeFi, including staking, investing, lending, profit farming, etc.
DeFi allows people to optimize profitability, join decentralized marketplaces, access banking services, and quickly borrow and lend. However, DeFi is not without risks; you should always do your due diligence before taking any risks.
Introduction
Entering the world of Decentralized Finance (DeFi) can be exciting, but also confusing. After holding for some time, the question often arises, how can you get additional income from your portfolio. However, when it comes to DeFi, there is a lot to talk about.
When used responsibly, DeFi dApps and projects can become powerful tools. But if you jump in too early, you can easily get confused and make unwise investment decisions. The best way to participate is to study the risks and find what works for you. With that in mind, let's go over the basics you'll need to start your DeFi journey.
What is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an ecosystem of financial applications built on blockchain networks. Namely, DeFi seeks to create an open, inclusive and transparent ecosystem of financial services that is accessible to all and operates without a central authority. Users retain full control over their assets and interact with this ecosystem through P2P, decentralized applications (dApps).
A major benefit of DeFi is easy access to financial services, especially for those isolated from the traditional financial system. Another advantage is the modular structure it is built on, with compatible DeFi applications on public blockchains. They have the potential to create entirely new financial markets, products and services.
Key benefits of DeFi
The traditional financial system relies on institutions such as banks that act as intermediaries and courts to ensure that disputes are resolved. DeFi programs do not need intermediaries or arbitrators. The code determines the resolution of every possible dispute, and users, for their part, keep all their funds under control. This automation reduces costs and makes the financial system simpler.
Since the deployment of the software of a new type of financial services is carried out on top of blockchain networks, there is no single point of failure in the system. Data is recorded on the blockchain and distributed among thousands of nodes, making censorship or possible shutdown of the service a difficult task.
Another important advantage of such an open ecosystem is the ease of access to financial services for people who, for whatever reason, do not have this opportunity. Because the traditional financial system is based on intermediation for profit, they usually do not offer their services in low-income areas. However, thanks to DeFi, operational costs are significantly reduced and such communities will also be able to benefit from the necessary financial services.
Potential DeFi Use Cases
Borrowing and lending
Open lending protocols are among the most popular types of programs in the DeFi ecosystem. Open, decentralized borrowing and lending has many advantages over a traditional credit system, including instant settlement of transactions, no credit checks, and the ability to secure digital assets.
Because these lending services are built on public blockchains, they minimize trust requirements and provide cryptographic verification. Credit marketplaces on the blockchain reduce counterparty risk, make loans and credits cheaper, faster and more accessible to more people.
Cash banking services
Since DeFi applications are financial by definition, monetary banking is an obvious use case. They can offer the issuance of stablecoins, mortgages and insurance.
As the blockchain industry develops, more and more attention is paid to the creation of stablecoins. These are crypto-assets that are usually tied to real assets and are easily transferred digitally. Because cryptocurrencies are highly volatile, decentralized stablecoins can be adopted for everyday use as digital money that is not issued or controlled by central authorities.
With smart contracts, mortgage underwriting and legal fees can be significantly reduced. Insurance on the blockchain can eliminate the need for intermediaries and allow risk to be distributed among many participants. This can lead to lower insurance premiums without affecting the quality of service.
Decentralized platforms
Some of the most popular DeFi programs are decentralized exchanges (DEXs) such as Uniswap and PancakeSwap. Such platforms allow users to trade digital assets without the involvement of a trusted intermediary (exchange) to hold your funds. Agreements are concluded directly between users' wallets using smart contracts.
Some exchanges, known as automated market makers (AMMs), use liquidity pools to facilitate trading without the need for a direct counterparty for your trade. Since such trading platforms require much less maintenance, decentralized exchanges charge lower transaction fees than their centralized counterparts.
Blockchain technology can also be used to issue and title a wide range of traditional financial instruments. Such applications will work in a decentralized manner, which eliminates the need for a single point of failure and custodians.
Profitability optimization
The DeFi dApp can be used to automate and optimize complex returns derived from staking, reward pools, and other interest-bearing products. This is sometimes called a profit farm.
For example, you can earn regular rewards from mining Bitcoin, delegating BNB or providing liquidity. A smart contract can collect your rewards, buy more of the underlying asset and reinvest it. This process will increase your interest, often greatly increasing your profits.
Using a smart contract saves time and optimizes compounding. Your funds are usually combined with the funds of other users, which means that the gas commission is distributed among all participants of the smart contract, which optimizes profitability.
The role of smart contracts in DeFi
Most of the existing and potential decentralized finance programs are related to the creation and execution of smart contracts. While a regular contract uses legal terminology to define the terms between the contracting entities, a smart contract uses computer code.
Because their terms are written in computer code, smart contracts can enforce those terms in an automated way. This ensures reliable execution and automation of a large number of business processes that currently require manual control.
Using smart contracts is faster, easier and reduces risks for both parties. However, smart contracts also create new types of risks. Since computer code is prone to errors and various vulnerabilities, your confidential information locked in smart contracts is at risk.
Challenges facing DeFi
Low productivity
Blockchains are inherently slower than their centralized counterparts, which affects applications built on top of them. DeFi application developers must consider such limitations and optimize their products accordingly. Layer 2 solutions such as Arbitrum and Optimism solve these problems by offering faster and cheaper transactions.
High risk of user error
DeFi programs shift responsibility from intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is especially challenging when products are deployed on top of immutable blockchains.
Bad user experience
Today, the use of DeFi applications requires additional efforts on the part of the user. For DeFi applications to be a key element of the global financial system, they must provide a tangible benefit that will influence users' willingness to abandon the traditional system. Recent improvements in user interfaces and educational resources help alleviate this problem.
Chaotic ecosystems
Finding the most suitable application for a particular use case can be a difficult task, and users should be able to find the best choice. Also, the problem is not only in creating programs, but also in thinking about how perfectly they can fit into the large ecosystem of decentralized finance.
Risks of DeFi
While the world of DeFi can offer attractive APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services and some of the risks are already familiar to you:
Counterparty risk
If you participate in cryptoloans or any other type of lending, you run the risk that the counterparty will not return its debt.
Regulatory risk
The legitimacy of certain services and projects can be difficult to verify. If you invest in a smart contract that later closes due to regulatory issues, your funds may be at risk. Recent actions and recommendations from global regulators impact the development and implementation of DeFi.
Token risk
The assets you hold have different levels of risk depending on their liquidity, reliability, token smart contract security, and the associated project and team. Since the DeFi space has many tokens with low market capitalization, token risk can be particularly high.
Software risk
Vulnerabilities in the code can undermine the security of the smart contracts in which you invest. Your wallet can also be compromised by connecting to DeFi dApps and giving them certain permissions. Security methods such as multi-signature wallets and insurance funds are emerging to address these risks.
Non-permanent losses
If you are staking in liquidity pools, a deviation from the price ratio you entered will result in the loss of a portion of the tokens deposited in the pool in the event of a withdrawal.
Access to DeFi projects
Ethereum has long been the traditional home for DeFi. However, many blockchains now have healthy DeFi ecosystems. Networks with smart contract capabilities such as BNB Chain, Solana, Polkadot, Avalanche, and newer Layer 2 solutions on Ethereum are popular choices.
Finding DeFi projects and protocols requires research. Online forums, messengers and websites can help you learn about new opportunities. However, be very careful with any information you find. Always check the safety of every project you read or hear about.
What do I need to access DeFi projects?
To start using a DeFi dApp you will need:
Compatible wallet: A wallet in the form of a browser extension, such as MetaMask, or a mobile wallet, such as Trust Wallet, will work. A custodial wallet (one where you don't own the private keys) is less likely to allow you to connect to a dApp.
Crypto Assets: This seems obvious, but you may need a mix of assets. For example, if you want to use a dApp on Ethereum, you will need ETH for gas fees and another token for whatever service you use.
DeFi and Traditional Finance (TradFi)
DeFi offers an open financial system for anyone with internet access, unlike traditional finance that relies on centralized institutions and regulatory bodies. However, DeFi and traditional finance are increasingly interacting. Banks and financial institutions are beginning to explore DeFi protocols, creating hybrid models that combine the benefits of both systems.
DeFi and Centralized Finance (CeFi)
In the crypto world, not all financial services are decentralized. For example, staking through a centralized exchange like Binance often requires you to give up your tokens. In this case, you must trust a centralized organization that works with your funds.
Most of the services offered will remain unchanged. They are likely done through the same DeFi platforms that the user can access directly. However, CeFi removes the often complex nature of self-management of DeFi investments. You may also have additional guarantees for your deposits.
CeFi is neither worse nor better than DeFi. Its suitability depends on your wishes and needs. While you may sacrifice some control in CeFi, you often get stronger guarantees and offload some of the responsibility of handling assets and executing transactions.
What is the difference between DeFi and open banking?
Open banking is a banking system in which third-party financial service providers are given secure access to financial data through an API. This allows the integration of accounts and data between banks and non-bank financial institutions, as well as providing access to new types of products and services within the framework of traditional financial institutions. In fact, it allows creating new types of products and services within the framework of the traditional financial system.
However, DeFi is a completely new financial system that is independent of the existing infrastructure. Sometimes DeFi is also referred to as open finance.
For example, open banking can enable the management of all traditional financial instruments in one application by securely receiving data from multiple banks and institutions.
For its part, decentralized finance can provide management of completely new types of financial instruments and new ways of interacting with them.
Results
DeFi has quickly created a self-sustaining value ecosystem that attracts capital, developers and new products. Although DeFi promises to revolutionize the financial sector, it is still a new field. The future of DeFi depends on continued technological progress, regulatory developments and increasing adoption. Continuous innovation to overcome the limitations and risks associated with DeFi is essential for sustainable growth.
Related articles
What is an Automated Market Maker (AMM)?
What are liquidity pools in DeFi and how do they work?
What is a profit farm in decentralized finance (DeFi)?
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